October 3, 2020

Liquidated damages and deposits in construction


Rob Kennaley Historically in Canadian common law, the courts will not require a party to pay a genuine or true penalty on grounds of public policy. Thus, at common law a “liquidated damages” clause which provides that a party must pay a specified sum if it breaches the contract will be unenforceable and struck as a penalty if the amount is a not “genuine pre-estimate of damages.” It is in this context that liquidated damages clauses have arisen in construction: they are commonly used to pre-determine the damages a contractor must pay to an owner, usually on a per-day basis, for any delays it is responsible for.  

To be enforceable at common law, the amount of a liquidated damages clause must represent, at the time the contract is entered into, the parties’ collective and genuine effort to reasonably determine what the damages will be. Thus, if parties to a $1 million contract with a six-month contract schedule agreed to a liquidated damages clause requiring the contractor to pay $100,000 for every day of delay, the clause would generally be struck as unenforceable. This is because it is unlikely the parties could have genuinely agreed that a day of delay would be worth $100,000. Practically speaking, liquidated damages clauses are accordingly often challenged, after the fact, on the basis that they were not (at the time of the contract) a genuine pre-estimate of damages. (We note that many a contract will now require the parties to expressly agree, in the contract itself, that the number set out is indeed a genuine pre-estimate which will not be challenged at a later date. These clauses should be taken seriously, for reasons we will discuss below.)

DEPOSITS ARE DIFFERENT. They are, historically, an exception to the general rule that penalties will not be enforced under a contract. Under this exception, a deposit can and will be forfeited even if the party that gets to keep it suffers no damages whatsoever.  For example, a purchaser under an Agreement of Purchase and Sale in a real estate transaction will generally forfeit the deposit even if the vendor subsequently sells the home for substantially more money, and suffers no losses whatsoever. In addition, at common law the amount of the deposit lost need not have any relationship to the value of the contract, whatsoever.

In Canada, however, our courts are both courts of common law and courts of equity.  Common law and equity are two distinct streams of legal principles each of which go back centuries, to old Kings in England. While the common law imposes legal principles based on precedents, equity imposes principles that are, generally speaking, based on what is fair in all of the circumstances. Equity can sometimes thus be applied to relieve against the otherwise harsh consequences of the common law. In this context of fairness, it is said that anyone who claims equitable relief “must do equity” and must come to the Court with “clean hands.”  

As regards deposits, equity can step in to relieve a party from the harsh consequences of the forfeiture if the Court finds that enforcing the provision would be unconscionable in all of the circumstances. Establishing that a clause is unconscionable, in turn, requires an inequality of bargaining power between the parties and a resulting bargain that is “improvident,” or unfair. Accordingly, where there is a true inequality of bargaining power between the parties and the resulting deposit requirement can be seen as manifestly unfair, equity may step in to relieve the party in default from the obligation to forfeit the deposit.

IT SHOULD BE UNDERSTOOD, however, that establishing inequality of bargaining power and an improvident bargain can be difficult to do. All things being equal, our Canadian Courts (from the Supreme Court of Canada on down) have made it clear they prefer to let the parties themselves determine the terms of their contracts, including what is and is not a breach and what will, and will not, occur in the event a breach occurs. As the Ontario Court of Appeal commented in the 2005 case of 869163 Ontario Ltd. v. Torrey Springs II Associates Ltd., 2005 Carswell Ont 2782, “Judicial enthusiasm for the refusal to enforce penalty clauses has waned in the face of a rising recognition of the advantages of allowing parties to define for themselves the consequences of breach.”  

Accordingly, and perhaps over-simply-put, parties should not assume they will be able to easily avoid the forfeiture of a deposit on the basis of unconscionability. It is not enough to show that the terms of the deposit are in and of themselves grossly improvident, or unfair. Rather, it requires a finding of inequality of bargaining power that may be very difficult to establish. Simply put, the Courts are inclined to allow sophisticated parties to negotiate the terms of their agreements. Although not impossible, it will generally be difficult to establish an inequality of bargaining power.

And there is this to be added: Recently, in Ontario, there are indications the Courts may abandon the traditional common law approach to liquidated damages in favour of using equity and the principles of unconscionability. To recall, the common law doctrine requires a rational connection between the amount of set out in the clause and the actual amount of damages suffered, failing it is not a genuine pre-estimate of the damages and is not enforceable. In Torrey Springs (referenced above) and in Redstone Enterprises Ltd. v. Simple Technology Inc., 2017 ONCA 282, however, the Ontario Court of Appeal has suggested that going forward it may decide to assess the appropriateness of a liquidated damages on the basis of unconscionability, alone. The upshot of this, of course, would be that a liquidated damages clause could be enforceable even if the amounts bear no relationship whatsoever to the actual damages to be suffered by the other side. The $100,000 per-day clause referenced above, for example, would conceivably be enforceable unless inequality of bargaining power could be established. We will, of course, keep readers apprised of developments in this regard. In the meantime, parties should take care to read their contracts and only agree to reasonable liquidated damages, deposit or other penalty clauses.   
Robert Kennaley practices construction law in Toronto and Simcoe, Ont. He speaks and writes on construction law issues and can be reached for comment at 416-700-4142 or at rjk@kennaley.ca. This material is for information purposes and is not intended to provide legal advice. Readers who have concerns about any particular circumstance are encouraged to seek independent legal advice in that regard.